Indirect taxes, subsidies, and price controls

IB Economics

Learning Objectives By the end of this section you should be able to

Define and give examples of an indirect tax Explain the difference between a specific tax and a percentage tax Explain the importance of elasticity in understanding the effect of a specific

tax on the demand for, and supply of, a product Explain how the imposition of an indirect tax may affect consumers,

producers and government Define a subsidy Explain how the granting of a subsidy may affect consumers, producers and

government Explain, distinguish between, illustrate and give examples of maximum and

minimum price controls Discuss the consequences of price controls on the stakeholders in a market HL - Explain the significance of the elasticity of demand and supply in

assessing the incidence of an indirect tax HL – using equations of linear functions, show and explain the effects of

indirect (specific) taxes on a market HL - illustrate and calculate how the incidence of tax differs for consumers,

producers and government HL – using equations of linear functions, show and explain the effects of

subsidies on a market HL – calculate the effects of minimum and maximum prices from diagrams

Indirect Taxes An indirect tax is a tax on

spending Government taxes the firm

which increases its costs The supply curve shifts

vertically by the amount of the tax

Less product is supplied at every price

The price increase There are two types of indirect

tax This diagram illustrates a

specific tax The shift is vertically upward

of the amount of the tax An example would be the tax

on a packet of cigarettes

Indirect tax – tax on expenditure

S

P1

specific tax – a fixed amount of tax that is imposed on a product e.g. $1 per unit

Quantity

S + tax

Q2

D

Q1

tax

P2

Pric

e

Indirect TaxesA percentage tax

increases as the selling price increases as shown in the diagram

An example would be VAT in the UK (currently 20%)

Indirect tax – tax on expenditure

A percentage tax (Ad Valorem) – the tax is the percentage of the selling price. As the price rises the tax will rise

Quantity

S + tax

Q2

D

Q1

S tax

P1

P2

tax

Pric

e

What effect will the tax have on consumers, producers, government and the market as a whole?

Let’s use the specific tax as an example

Before the tax the firm’s revenue is Q1xP1 (the blue square)

When the tax of XY is charged the firm would like to pass it all onto the consumer by raising the price to P2

At that price we can see there is an excess of supply

The price falls to a new equilibrium at P3

S

P1

Quantity

S + tax

Q3

D

Q1

XY

P2P3

Pric

e

What effect will the tax have on consumers, producers, government and the market as a whole?

The price is now P3 and has increased from P1

The consumer is paying a higher price

We can see that the tax burden is roughly shared about ½ and ½

Burden of the tax – who pays the tax

S

P1

Quantity

S + tax

Q2

D

Q1

XY

P3

C

Consumer tax

Producer tax

Pric

e

What effect will the tax have on consumers, producers, government and the market as a whole?

The producer is now only receiving C per unit

The firm’s revenue was Q1P1 (blue)

The firm’s revenue has decreased to Q3C (yellow)

S

P1

Quantity

S + tax

Q3

D

Q1

XY

P3

C

Pric

e

What effect will the tax have on consumers, producers, government and the market as a whole?

The government gains tax revenue of XY x Q3 (quantity x tax (purple))

The market falls in size from Q1 to Q3 which could mean unemployment in that in that industry (derived demand for labour)

S

P1

Quantity

S + tax

Q3

D

Q1

XY

P3

C

Pric

e

Time for you to do some work!!Read through pages 63-64Complete the student workpoint P65Complete Exam Q’s 1 on P75

Only 1a if you are SL1a and b if you are HL (after the next slides)

HL bit!

The tax burden & elasticity The outcome of the share of tax

burden, the amount of producer/government revenue and the size of the market depends on the PED and PES

Firstly we will look at what happens when the PED is relatively elastic and the PES is inelastic

Initially equilibrium is at P1Q1

With the specific tax of XY the supply curve shifts to S+tax

There is a new equilibrium of P2Q2

The consumer pays P1P2Q2 in tax The producer pays CP1Q2 in tax We can see that the producer is

paying much more of the tax This is because the PED elastic;

the firm knows that the consumer is price sensitive; if the price goes too high the consumer will stop buying the product

They have to bear most of the burden of the tax

S

P1

Quantity

S + tax (XY)

Q2

D

Q1

X

P2

C

Y

Pric

e

The tax burden & elasticity Now we will look at what happens

when the PED is relatively inelastic and the PES is elastic

Initially equilibrium is at P1Q1

With the specific tax of XY the supply curve shifts to S+tax

There is a new equilibrium of P2Q2

The consumer pays P1P2Q2 in tax

The producer pays CP1Q2 in tax We can see that the consumer is

paying much more of the tax This is because the PED is

inelastic; the firm knows that if the consumer is not sensitive to price; if the price is increased the consumer % demand will not change as much as the % change in price

The consumer bears most of the burden of the tax

S

P1

Quantity

S + tax (XY)

Q2

D

Q1

X

P2

C Y

Pric

e

The rules When PED = PES the burden of tax will be

equal between the consumer and producer

When PED is greater than PES the burden of tax will be greater for the producer

When PED is less than PES the burden of tax will be greater for the consumer

This is why governments like to place taxes on products that have relatively inelastic demand such as alcohol or cigarettesThe market will not reduce in size too much

because consumers are price insensitive which protects unemployment

And still there will be large tax revenues

Time for you to do some work!!Read through pages 65-66 / make notesComplete the student workpointCover the answers of the assessment advice (P67), see if you can answer the question and then check your answersNow you can complete 1b from P75

Pajholden videos• Indirect taxation

– http://www.youtube.com/watch?v=t9N4La0-k9c

Subsidies (for all)

Subsidy When a subsidy is given to a firm

it’s costs are lowered and therefore it will supply more.

Percentage subsidies are rare so we concentrate on specific subsidies

The supply curve shifts to the right as seen in the diagram

It shifts by the amount of the subsidy

There are several reasons why government gives subsidies

To lower the price of essential goods to increase consumption (e.g. milk)

To guarantee the supply of goods in an industry the government believes is necessary e.g. coal

To help producers compete overseas (protection of industries)

Subsidy – an amount of money paid by the government to a firm per unit of output

S+subsidy

P2

Quantity

S

Q1

D

Q2

subsidy

P1

Pric

e

Subsidy We can see that when

the subsidy is given to the firm the price reduces from P1 to P2 which is not the whole subsidy

If the whole subsidy was given the price would drop to P3 (HL - depending on elasticities)

We can now look at the effect on producer revenue, consumer expenditure and government spending

Subsidy – an amount of money paid by the government to a firm per unit of output

S+subsidy

P2

Quantity

S

Q1

D

Q2

subsidy

P1

Pric

e

P3

Producer RevenuePrior to the subsidy

the firm would be making P1Q1 in revenue (blue box)

If a subsidy of WZ is given by the government

The firm is now making Q2D (yellow plus box) in revenue

Revenue has increased by the yellow amount

Subsidy – an amount of money paid by the government to a firm per unit of output

S+subsidy

P2

Quantity

S

Q1

D

Q2

P1

Pric

e

D W

Z

Consumer expenditure Prior to the subsidy

consumers could buy Q1 at the price of P1

They can now buy Q1 at the price of P2 so they make a saving of P1-P2 x Q1 (pink box)

However they will purchase more units at the lower price of Q2-Q1

The extra expenditure is Q2-Q1 x P2 (purple box)

Total expenditure may increase or fall depending upon relative savings and extra expenditure

Subsidy – an amount of money paid by the government to a firm per unit of output

S+subsidy

P2

Quantity

S

Q1

D

Q2

P1

Pric

e

D W

Z

Government expenditure

Government expenditure is the shaded area DWP2Z

This money has to be found somewhere

There is an opportunity cost Government can either take

this away from other areas of spending (building infrastructure, providing public services)

Or it must raise taxes (unpopular with voters)

Or it could borrow money and increase debt

Subsidy – an amount of money paid by the government to a firm per unit of output

S+subsidy

P2

Quantity

S

Q1

D

Q2

P1

Pric

e

D W

Z

Evaluation of Subsidies The issue of the opportunity cost Does the subsidy allow firms to be

inefficient In a free market they might have to be

more efficient to compete (on price) Although the subsidy allows consumers to

pay a lower price they may also be the taxpayers that are funding the subsidy

Subsidies can lead to overproduction There is a great deal of international

debate about subsidies given to farmers in high income countries

This leads to overproduction and is damaging to farmers in developing countries that cannot compete

High income countries are accused of dumping their products in developing countries (we will learn more about this later)

Pajholden videos• Subsidies

– http://www.youtube.com/watch?v=NykcR3RhyR4

Time for you to do some work!!Read through pages 68-69 / Make notesComplete all of the student workpoints (only one if you are SL) Complete Exam Q 2a and b on P75

Price ControlsWatch the mjmfoodie videohttp://www.youtube.com/watc

h?v=XgBPAucs-W4

Time for you to do some work!!Read through pages 70-74 / Make notes

Miss out the assessment advice on P72 if you are SLComplete all of the student workpoints (one extra if you are HL) Complete Exam Q 3a and b on P75Complete the Data Response Question on P76

Pajholden videos• Indirect taxation

– http://www.youtube.com/watch?v=t9N4La0-k9c

• Subsidies– http://www.youtube.com/watch?v=NykcR3Rhy

R4

Mjmfoodie video

• Price floors and ceilingshttp://www.youtube.com/watch?v

=XgBPAucs-W4